The temporary loss is one of the biggest risks associated with putting your crypto in a liquidity pool.
In this guide, we’ll break down everything you need to know about temporary losses – including steps you can take to limit your risk!
What is Impermanent Loss?
A temporary loss occurs when the price of the crypto assets in a liquidity pool changes relative to each other. This means that the balance of assets within the pool will shift in favor of the underperforming asset.
How do liquidity pools work?
To better understand how volatile loss works, let’s go through the basics of how liquidity works in both centralized and decentralized exchanges.
Where does liquidity come from in a centralized exchange?
In a traditional exchange, centralized players like Coinbase provide the liquidity needed to execute trades. For example, if you want to exchange DAI for ETH on Coinbase, Coinbase will sell you ETH from its own inventory.
Where does liquidity come from in a decentralized exchange?
Decentralized protocols don’t rely on centralized market makers like they do coin base. Instead logs like Uniswap Rely on liquidity pools where users can contribute their own cryptocurrency to be used as liquidity in trading.
Most liquidity pools allow users to deposit two or more crypto assets. In return, liquidity providers receive transaction fees from swaps facilitated by the liquidity pools.
For example, let’s say you own ETH and wBTC. Instead of simply holding your cryptocurrencies, you can put them in a liquidity pool where investors can trade ETH for wBTC and vice versa. In return, you receive transaction fees from these swaps.
How do liquidity pools determine the mix of different assets?
Liquidity pools typically use the following formula to determine the total amount of the various assets included in the pools.
X*Y=K
In this case, X is the total value of the first asset, Y is the total value of the second asset, and K is a constant value.
As a result, the “mix” of assets included in the liquidity pool can change drastically as the price of each asset changes.
Example of a temporary loss
Let’s look at an example to better understand how fickle loss works.
Jonathan deposits $500 Ethereum and $500 Polygon into a $10,000 liquidity pool. Jonathan is entitled to 10% of the value of the liquidity pool ($1,000/$10,000).
Jonathan’s ETH rises in value to $1,000 while Polygon’s value stays the same.
The liquidity pool will be rebalanced to include less ETH and more polygon.
The value of the liquidity pool increases to $13,000.
Jonathan withdraws his holdings for $1,300 – $650 worth of ETH and $650 worth of Polygon.
While Jonathan made a profit, if he had simply stuck with his cryptocurrency ($1,000 ETH and $500 Polygon), his fortune would have been worth $1,500. That $200 difference between his potential and realized gains is what we would call “fickle loss.”
It’s important to remember that this is a simplified example. We have not considered the transaction fees Jonathan could potentially earn for depositing his cryptocurrency in a liquidity pool.
Can you recover from an inconsistent loss?
It is possible to recover from temporary losses when the ratio of assets in the liquidity pools returns to previous levels. However, two uncorrelated assets are not guaranteed to return to previous levels after a large price change.
How does impermanent loss come about?
A temporary loss occurs when crypto prices are volatile. When the price of cryptocurrencies changes relative to each other, the balance of assets in a liquidity pool changes as traders take advantage of the arbitrage opportunity – resulting in fickle losses.
How to calculate temporary loss
To estimate your temporary loss, determine the current value of your initial deposit. Next, determine the current value of your share of the liquidity pool. The difference between these two values is your fickle loss.
Here’s a formula you can use to calculate temporary loss.
Current initial deposit value – current value of your share of the staking pool = temporary loss
How risky is a temporary loss?
The temporary loss is a risk that should be considered every time you deposit your cryptocurrency into a liquidity pool.
However, you should weigh the risk of temporary loss against the potential benefits of receiving transaction fees from a liquidity pool.
In addition, it is important to remember that the cryptocurrency market is volatile and any exposure may be considered “risky”.
How to avoid fickle loss?
Unfortunately, there is no way to completely avoid fickle losses when using DeFi protocols. However, there are measures you can take to reduce the likelihood.
A temporary loss is more likely to occur if you escrow ephemeral token pairs. It’s less likely to occur if you’re depositing cryptocurrencies that are highly correlated in price – such as B. two pairs of stablecoins.
Some protocols such as Curve offer liquidity pools with similarly behaving assets to minimize the risk of temporary losses.
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